The Eight Accounting Fraud or Red Flag Signs To Look Out In Stocks
10 August 2020
In this article, I’d like to share eight signs of potential fraud in our stocks portfolio that we should be careful of.
These are eight simple potential warning signs of bad financial reporting or early markers of fraud for stocks in our portfolio that I personally find useful.
Kindly note that these warning signs do not necessarily mean that a company is 100% confirmed to fraudulent; it is just some of the markers that I think we should be wary of.
1. Growth in revenue much higher than it’s peers
If a company’s revenue growth seems like it is too good to be true, sometimes it is.
Luckin Coffee’s amazing revenue growth was fake. There were a lot of fraudulent fake revenue transactions behind it.
So if the company has a revenue growth that is much higher than it’s peers, we should deep dive into it.
2. The rate of account receivable grows much faster than it’s growth in revenue
If a company’s account receivable grows much faster than it’s revenue, it could potentially be a warning sign.
For one, it is obvious that the company is collecting payments at a slower rate than sales.
This might be because customers are paying up late or the credit terms that the company offers its customers are too favorable.
Or the worse case, there might be fictitious billing.
3. A large proportion of its revenue is booked in the last quarter even though it is a non-seasonal business
It is common sense that a non-seasonal business should not always have a large proportion of its revenue booked in the last quarter of the year.
So if that is the case, it is a cause of concern because there might be fictitious revenue to window dress the company’s results.
4. Cash flow from operations is much lower than operating income
If cash flow from operations is much lower than operating income, the company’s quality of earnings is questionable.
It might also be a sign of fake sales invoices whereby not much cash is coming in.
A high-quality business on the other hand usually has cash flow from operations that match or exceed operating income.
5. Aggressive accounting assumptions are used
For example, see how the company recognizes it’s sales. If revenue is recognized before the company has fulfilled all obligations associated with the sales, that is an overly aggressive accounting assumption.
Another example of aggressive accounting is recognizing expenses as an asset instead of charging those expenses as incurred.
6. Typical current assets like inventory and account receivable are included in non-current assets
Current assets should be stated as current assets. If a company list it’s current assets as non-current assets, that is a red flag.
7. High goodwill relative to total assets value
If a company has too much of goodwill relative to its total asset value, that is very dangerous because they are all potential impairments in the future.
That is a big warning sign when a company has so much high goodwill relative to total assets value or even worse, market capitalization.
Because goodwill is, after all, a representation of future potential economic benefits through the price paid above the fair and tangible value of the assets.
When goodwill is so high in comparison to the total asset or market capitalization, it is likely that the company has made a horrible acquisition and impairment is about to come.
8. Use of special purpose vehicle
Using a special purpose vehicle for whatever reasons like to lower taxes has to be looked upon carefully.
Especially if there are complex and difficult to understand related party transactions.
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In a fraud, everything is clearer in hindsight. But there are always markers such as in the case of the Luckin Coffee and Wirecard scandals. There are early markers for these two companies many years before they are officially proven to be fraudulent.
I felt that these are just eight of the potential fraud/red flags that we should take note of and consider. And perhaps dive deeper when a few of these things show up together.
Personally, I also look into the Beneish M-Score for some companies that I find suspicious. The Beneish model is simply a statistical model to check the probability that whether the reported earnings have been manipulated or not.
The information provided is for educational and general information purposes only and is not intended to be personalized investment or financial advice. We make no promises as to the accuracy or usefulness of the information we present.
Important: Please read our full disclaimer.
Chris Lee Susanto
Founder of the value investing blog Re-ThinkWealth.com (if you type “value investing blog” in Google, his blog is likely the first one). Being a full-time investor himself, Chris knows that he did not beat the S&P 500 return so far (as of the time of this writing) by listening to stock tips. So, when he teaches, he also doesn’t believe in giving stock tips as it is not sustainable for you in the long run. He will teach you how to make your own intelligent decisions with his 4M1S framework. Feel free to also join his free investment telegram channel here.
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